Overview

Payday loans typically carry annual percentage rates of 300 to 500 percent and are due on the borrower’s next payday (roughly two weeks later) in lump-sum payments that consume about a third of the average customer’s paycheck, making the loans difficult to repay without borrowing again. They are characterized by unaffordable payments, unreasonable loan terms, and unnecessarily high costs.

In June 2016, the Consumer Financial Protection Bureau (CFPB) proposed a rule to govern payday and auto title loans1 that would establish a process for determining applicants’ ability to repay a loan but would not limit loan size, payment amount, cost, or other terms. The CFPB solicited and is reviewing public comments on whether to include in its final rule alternatives to this process with stronger safeguards, particularly a 5 percent payment option that would limit installment payments to 5 percent of monthly income, enabling banks and credit unions to issue loans at prices six times lower than those of payday lenders, making lower-cost credit available at scale. An analysis by The Pew Charitable Trusts determined that the CFPB’s proposal would accelerate a shift from lump-sum to installment lending but, without the 5 percent option, would shut banks and credit unions out of the market, missing an opportunity to save consumers billions of dollars a year.2

Previous Pew research found that payday loan borrowers want regulatory action to reform payday lending and expand lower-cost credit options, so in light of the CFPB proposal, Pew conducted a new nationally representative survey of 826 borrowers and found that:

70 percent of borrowers believe payday loans should be more regulated.

Support for requiring installment payment structures is strong. Three in 4 borrowers say having several months to repay and doing so in smaller installments would be major improvements, but most say additional underwriting would not.

Borrowers’ priorities for reform include lower prices, affordable payments, and being able to obtain small loans from banks and credit unions.

8 in 10 would prefer to borrow from a bank or credit union if they were equally likely to be approved, and 90 percent would do so if the loans cost six times less than those of payday lenders. The pricing differential is based on payday lender fees for loans and on prices financial institutions would reportedly offer.

Virtually all would choose loans that cost six times less. Ninety-two percent of borrowers say they would prefer the lower-cost credit that banks and credit unions would likely offer under the 5 percent payment option. Only 5 percent would opt for more expensive payday installment loans that went through the proposed ability-to-repay origination process.

These findings show that payday loan borrowers strongly favor reform and are especially supportive of steps that would encourage lower-cost bank and credit union loans. A separate survey of American adults found that the public shares these sentiments.3 This chartbook discusses recommended changes to the proposal, including adoption of the 5 percent option, which is supported by Pew as well as many banks, community groups, and credit unions.

Those who cited multiple factors as “very important” were asked which was the most important. Thirty-nine percent chose “the fee charged”; 24 percent chose “how quickly you can get the money”; 21 percent chose “the certainty that you will be approved for the loan”; 11 percent chose “the loan amount”; and 6 percent chose “how easy it is to apply for the loan.”

Roughly 12 million Americans use payday loans annually, spending an average of $520 in fees to repeatedly borrow $375.4

In 2010, Colorado enacted a successful payday lending reform that led to the closure of more than half of payday loan stores over the ensuing five years but also doubled the number of customers served at each remaining stzore. The state required prices to be roughly three times lower than before the law changed, and lenders responded with improved efficiency. As a result, credit remains widely available, but loan payments now consume an average of 4 percent of a borrower’s paycheck instead of the previous 38 percent. The reforms have saved Colorado borrowers more than $40 million annually.5

Every payday loan customer has a checking account at a bank or credit union because it is a loan requirement. Most customers would prefer borrowing from their bank or credit union instead of a payday lender as long as they were equally likely to be approved, but they cannot do so because regulatory uncertainty has made it difficult for banks and credit unions to issue small loans. Many financial institutions have expressed an interest in offering lower-cost, small-dollar credit to their customers who use payday loans, but only if they receive clear regulatory guidance that enables them to do so with simple underwriting.

In May 2016, American Banker reported that at least three large banks were planning to offer small loans, repayable in affordable installments, at prices that were roughly six times lower than those of average payday loans.6 Given the choice, most borrowers say they would use these lower-cost bank or credit union loans rather than payday loans. Financial institutions have stated that they would not be able to offer such loans under the CFPB’s proposed ability-to-repay (ATR) test but would under the 5 percent payment alternative. Several bank and credit union trade associations have asked the bureau to include the 5 percent payment option in the final rule.7

If borrowers of high-cost credit were able to access loans from banks and credit unions that cost six times less than those offered by payday lenders, Pew estimates they would save more than $10 billion annually, more than the United States spends on some major anti-poverty programs such as Temporary Assistance for Needy Families basic assistance and Head Start.8 Borrowers reacted positively to the idea of banks and credit unions offering lower-cost small loans.

When presented with possible components of the CFPB’s final regulation, borrowers said loans with lower prices, more affordable payments, and reasonable installment structures would be a major improvement, but most said a debt evaluation process or a limit on the number of installment loans they could use was “not an improvement” or only a “minor improvement.” The outcomes borrowers favored most were those that would probably result from the 5 percent payment option. The proposed rule relies heavily on a specific origination process that would make offering lower-cost installment loans at scale too difficult for banks and credit unions, but these institutions say they would be likely to offer such loans if the CFPB includes the 5 percent payment option in its final rule.

Under the CFPB’s proposed ATR provisions in which lenders would pull borrowers’ credit reports, use a real-time database, and have an estimate of similar people’s expenses, $1,250 and $500 loans, repayable in 10 and five months for $2,450 and $595 in fees, respectively, would probably continue to be offered. The bureau’s commentary on the proposed rule stated that most payday installment loan borrowers would pass an ATR test for monthly payments of more than $300, which is larger than the monthly payments for many payday installment loans and more than borrowers say they can afford.9

Banks and credit unions could offer five-month loans of $500 for a $125 fee under a 5 percent payment option, which borrowers say compare favorably to the $500 loans with $750 fees that payday lenders would be likely to issue under the proposed ATR provision. Unless the proposed regulations are modified, high-cost loans are the only ones likely to be widely available.

If banks are allowed to issue loans under the 5 percent payment option using the borrower’s checking account history and income information for underwriting purposes, they will be likely to offer a three-month loan of $500 for $75 in fees. Most borrowers would choose this loan over a $500 loan with $450 in fees that payday lenders would be likely to issue under the proposed ATR provision.

Advocates of payday loans frequently point to the help that readily available, small-dollar credit provides to borrowers when financial difficulties arise. And although borrowers agree that credit can be beneficial, they say cost is a major factor in determining whether loans are helpful. Banks would be likely to offer loans of $400 for a fee of about $60 if the 5 percent payment option is included in the CFPB’s final rule, while payday lenders would charge fees of around $350 for the same $400 loan issued under the proposed longer-term ATR provision, meaning borrowers view the potential bank loans as far more helpful than payday installment loans. The bank loan with a $60 fee would have an APR of 88 percent, compared with an APR of 473 percent for the payday loan.

Consumers are interested in obtaining loans through online banking and other channels. To keep costs down, banks would need to be able to issue loans using electronic and other automated methods that do not require staff time to process applications or disburse funds, but banks need clear standards to support such automation for lower-cost small-dollar loans. The ability to prescreen customers for eligibility, automate the origination process, and deposit proceeds immediately into checking accounts are the factors that would enable banks to profitably offer small loans at prices much lower than those of payday lenders.

As shown in Figure 9 on Page 11, 9 in 10 borrowers see a $35 fee for a $300, three-month loan as fair, but 3 in 4 believe it is unfair to charge the same amount for a checking account overdraft. Current regulation does not support borrower preferences because it permits such overdraft fees but does not enable banks to offer lower-cost small-dollar loans at scale.

Emphasizing annual percentage rate information does little to dissuade borrowing, deterring only about 1 in 10 respondents: When APRs are featured prominently, 57 percent of payday loan borrowers say they would be likely to use such a loan if short on cash, compared with 68 percent when APR is not highlighted.

Methodology

On behalf of The Pew Charitable Trusts, the GfK Group conducted a national study of 826 payday loan borrowers Aug. 23-28, 2016. The survey was conducted using KnowledgePanel, a probability-based web panel designed to be representative of the United States. The survey consisted of two stages: initial screening for borrowers and the main survey with the study-eligible respondents. To qualify for the main survey, a panel member must have used a payday loan (at a store or online).

The margin of error including the design effect is plus or minus 4 percent at the 95 percent confidence level. A detailed methodology is available at http://www.gfk.com.

The Pew Charitable Trusts et al., group comment letter on the CFPB’s Notice of Proposed Rulemaking for Payday, Vehicle Title, and Certain High-Cost Installment Loans, Oct. 6, 2016, https://www.regulations.gov/document?D=CFPB-2016-0025-142119. The signatories on this letter include nonprofit leaders, credit counselors, researchers, and representatives of banks that collectively operate 1 in 6 bank branches in the United States.

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